Between a Rock and a Hard Place!

The American Rescue Plan Act is wonderful news for plan participants stuck in struggling multiemployer plans, especially in those specific cases where benefits have been cut under MPRA (18 plans in total). It is found money that improves the plan’s funded status. But as I've mentioned through various outlets the legislation falls far short in providing the necessary assistance to ensure that the promised benefits are actually paid until 2051. Worse, it appears that many of the roughly 130 plans eligible for this federal assistance will become insolvent prior to then.

We, at Ryan ALM, have been espousing that the Special Financial Assistance (SFA) should be managed with a liability focus that will ensure that benefits and expenses are matched carefully with SFA assets (100% fixed income). We have also been saying that the legacy assets and the SFA should be looked at as a single team of assets for asset allocation purposes. In that scenario, the legacy assets can be managed with a greater exposure to performance assets by removing the allocation to fixed income here since fixed income is 100% of the SFA portfolio. This should enhance the probability of achieving a higher ROA on the legacy assets. The SFA assets are liquidity assets whose mission is to cash flow match (defease) benefits chronologically which will buy time for the performance assets to grow unencumbered.

Since the new SFA assets enhance the funded status, a new adjusted ROA should be calculated for the legacy assets only, so they know the economic hurdle rate to reach a fully funded plan. This new economic ROA is best calculated on a net liability basis including projected contributions. We highly recommend an Asset Exhaustion Test (AET) as the methodology to calculate this new economic ROA hurdle rate. Once this new ROA is calculated, the asset allocation for the legacy assets can now be assessed with a clear knowledge of its return mission. 

By defeasing liabilities for an extended period of time (8-12 years or more) the asset allocation investing horizon for the legacy assets is dramatically increased allowing for these assets to grow unencumbered as they are no longer a source of liquidity. The S&P 500 has outperformed bonds in 82% of rolling 10-year periods. I like those odds, but the current equity environment may not be a "normal" environment. Two charts produced by Bloomberg provide me with ample angst! The chart titled American Revenues Don't Come Cheap highlights the US P/S multiple versus the rest of the world and reflects a valuation more than twice as great as the S&P 500/MSCI ACWI. As a point of reference, the US P/S ratio was only 0.9 when the market crashed in October 1987.

Worse, Robert Shiller’s cyclically adjusted price-earnings multiple, or CAPE, which compares an index’s price to average inflation-adjusted earnings over the previous decade is at a level not seen since 2000, which represented the all-time high. The chart below forecasts the subsequent 10-year return for US equities versus bonds by calculating the excess CAPE yield, or ECY, which is the gap between the CAPE earnings yield (the inverse of the ratio) and the 10-year bond yield. At 3%, the forecasted outperformance of equities to bonds is not nearly enough to get plans to the ROA especially with the 10-year Treasury note currently sitting at a yield of just 1.28%.

Given where equities are at this time, plan sponsors and their consultants will need to get quite creative with their asset allocations for legacy assets in order to create a potentially winning formula in their quest to achieve the new economic ROA. It appears to us that the only certainty of success resides in the SFA bucket if the assets are defeased to the plan's liabilities and expenses. Time will help this situation, but is 10-years a long enough time horizon given where valuations currently reside? If the markets aren't going to help mitigate some of the funding shortfall, perhaps we can hope that Congress will once again take up pension reform to provide the necessary resources to ensure that the currently struggling pension systems can remain solvent long after 2051.

The Custom Liability Index (CLI) - A Necessary DB Pension tool

I stumbled onto an article from 2008 that spoke to Ron Ryan's "genius" when it comes to indexing. As most of you know, Ron was the Director of Research at Lehman in the '70s and he has been credited with creating many of the world's leading fixed income indexes, most notably the Aggregate, now known at the Bloomberg Barclays US Aggregate Bond Index. This article mostly dealt with his (Ryan ALM's) work with ETFs, but I think that his most notable contribution to indexation has been the creation of the Custom Liability Index (CLI). I believe that every DB pension plan should have a CLI produced for them as each pension liability stream is unique and NO generic bond index can adequately match.

I am still amazed, even after 40-years in this business, that a plan's liabilities aren't driving asset allocation and investment decisions. The lack of liability information is certainly one of the primary reasons why this continues to occur. With a CLI, plan sponsors have the necessary information at their fingertips when it is needed. In 1991, Ron Ryan and his team invented the first CLI as the best representation of the true client objective. Although funding liabilities is the true objective of any pension, liabilities tend to be missing in action in asset allocation, asset/liability management, and performance measurement. The reason for this disconnect is the absence of a Custom Liability Index (CLI) that best represents the future value, present value, term structure, and risk/reward behavior of liabilities. Once a CLI is installed as the proper benchmark, then and only then can the asset side function effectively on asset allocation, asset/liability management and performance measurement.

As mentioned, liabilities are like snowflakes… you will never find two alike. Pension liabilities are unique to each plan sponsor since they each have a different labor force with a different salary structure, mortality, and plan amendments than any other pension. As a result, only a Custom Liability Index could ever properly represent or measure the unique liabilities of any pension. A CLI should be calculated accurately and frequently so the plan sponsor and its pension consultant can be informed with timely data that can support the asset allocation decisions.

Assets need to know what they are funding. The economic truth is that assets fund the net liabilities after contributions. A CLI should provide a net liability valuation based on all discount rates that apply (ASC 715, ROA, ROA bifurcated with 20-year munis, Treasury STRIPS, PPA spot rates, PPA 3-segment, PBGC). Ryan ALM is one of few vendors supplying ASC 715 discount rates since 2008. Our discount rates are consistently higher than other vendors providing a lower present value on liabilities thereby enhancing funded ratios and balance sheets. It may be wise for the CLI to have the economic valuation (U.S. Treasury STRIPS) as one of the discount rates to compare actuarial and accounting valuation versus economic valuation. Moreover, the CLI will provide a monthly or quarterly calculation of the economic present value of liabilities so the funded ratio and funded status can be updated, as well as a quarterly calculation of the economic liability growth rate so performance measurement of total assets versus total liabilities can be assessed.

Since current assets fund net liabilities after contributions, current assets need to know the projected benefits and contributions for every year as far out as the actuary calculates benefits. Noticeably, contributions usually play no role in the asset allocation strategy of most pensions, yet they are a major future asset. Given the size of contributions today, it is critical that contributions are a major consideration in the asset allocation strategy. For many plan sponsors, the contribution cost has risen as much as 5x to 10x or more from the fiscal 1999 level.

Don't hesitate to reach out to us if you are interested in learning more about the Ryan ALM CLI. Without this pension X-ray, it is difficult to truly know what is ailing your plan.

Ryan ALM Quarterly Newsletter - 2Q'21

We are pleased to share with you the Ryan ALM Quarterly Newsletter. The newsletter contains important insights on pension assets and liabilities during the quarter and for the last 20+ years. In addition, we share with you the latest research and a sampling of blog posts produced by us during the last 3 months. We hope that you find our insights beneficial. Lastly, please don't hesitate to reach out to us with any questions and/or comments.

Ryan ALM's Pension Monitor

Each quarter, Ryan ALM produces the "Pension Monitor" to reflect how pension liabilities are behaving versus plan assets. We believe that pension plan liabilities need to be measured and monitored regularly. Without knowledge of plan liabilities, the allocation of plan assets cannot be done appropriately. 

The funded ratio/status of pension plans are present value calculations. Each type of plan is governed by accounting rules and actuarial practices, which determine the discount rate used to calculate the present value of liabilities. Single employer corporate plans are under ASC 715 (FASB) discount rates (AA corporate zero-coupon yield curve); multiemployer plans and public plans use the ROA (return on asset assumption) as the liability discount rate. The difference in liability growth between these plans can be quite significant, which will affect funded status and contribution levels. 

Given the strong rebound in markets following the onset of Covid-19, it shouldn't be surprising to see that assets have outperformed liabilities during the last 15 months. Whether the plan is a public, corporate, or multiemployer plan, assets have been aided by strong equity markets and liability growth has been muted by rising interest rates. This combination has been great for pensions that have witnessed strengthening funded ratios and improved funded status.

Please don't hesitate to reach out to us if we can answer any questions related to asset/liability management.

ARPA - "The Almost Rescue Plan"

The Pension Benefit Guaranty Corporation (PBGC) released their long-awaited American Rescue Plan Act (ARPA) guidelines. They had 120 days from the time that the legislation was signed by President Biden to inform the public on how this legislation would be implemented. I'd give them a C-, at best!

Importantly, retirees who had seen their benefits slashed under MPRA will FINALLY be made whole (18 multiemployer plans). I still shake my head at the fact that our "leaders" had passed legislation in 2014 that permitted promised (earned) benefits to be taken away from retirees, and in many cases after they had already retired through no fault of their own. Thankfully, help is now arriving for these retirees, but it could be a ways off based on the PBGC's priority filing schedule. According to PBGC's release, participants in these plans can have their benefits restored prior to their priority group (Group 2) being able to submit an application, but they must file with the US Treasury Department to accomplish this objective. Make up payments for those that had received cuts can only be made after their pension fund submits an application and receives Special Financial Assistance (SFA). This could take some time.

Where I take great umbrage is in the PBGC's interpretation of how the SFA should be calculated. Instead of taking a present value calculation of what it would take to secure the next 30-years of promised benefits (until 2051), the PBGC has decided that plans should include current assets, future contributions, and the earnings from both before determining the "gap" that exists in order to meet the 30-years of benefit payments. What this does is effectively doom those plans that are receiving the SFA to insolvency in 2051, as NOTHING will be left to meet benefit payments in 2052 and beyond. Again, great that current retirees are going to be made whole, but it does nothing to secure the benefits of those younger workers that will be just starting a career and contributing to their union's plan with the hope that they too will have a retirement benefit waiting for them when they finally retire. Can you imagine making a mortgage payment only to have someone else live in your house?

It gets worse. The discount rate used in the legislation does not reflect reality. The legislation calls for the PPA's 3rd segment rate plus 200 bps (5.5% currently) instead of PPA's 1st, 2nd, and 3rd rates weighted to the projected benefit payments that will be made during the next 30 years. This higher discount rate will significantly reduce the SFA so that the SFA will likely fall about 40% short of what is truly needed to ensure that the promised benefits are there until 2051.

According to the PBGC they were not able to address this discount rate because it was specifically stated in the legislation. Where are the pension experts in the room when you need them? Furthermore, the PBGC has reiterated that the SFA assets received should be segregated from current assets. The SFA assets must be invested in investment grade (IG) bonds with the exception of a maximum 5% that could be held in High Yield instruments that may have started out as IG but suffered downgrades since being purchased. The yield differential between the discount rate and the potential return on the SFA assets is what creates that additional roughly 40% shortfall. Again, good luck!

It appears to me that the legislation was passed with a targeted dollar amount as a goal, but that fact wasn't disclosed. The legislation scored by OMB had an $86 billion price tag. According to PBGC's Friday release, the "price tag" is estimated at $94 billion today. If the discount rate and SFA calculations had been adjusted as I suggest, the price tag would have been far greater. Instead of doing the right thing to secure the benefits for retirees without destroying these plans in the future, they chose to be penny wise and pound foolish.

The social safety net is going to be a lot more expensive when current employees see their pension plans collapse in less than 30-years. What appeared to be landmark legislation when it was first signed in March is now just another "Almost Rescue Plan Act". When will we finally do right by the American worker?

After a brief respite...

With most of the pension world expecting US interest rates to rise, the opposite has occurred and rather dramatically. US 30-year Treasury bond yields have collapsed 51 bps since May 12th, while the US 10-year Treasury note yield is down 41 bps during the same time frame. Since most DB pension plans, especially in the public sector, have liabilities with 10-15 year durations the impact on liabilities and funded ratios has been significant. For instance, a -40 bps move on 10-year duration liabilities = 4% growth, while a similar interest rate change on a 15-year duration liability = 6% growth. The improved funded status that we witnessed earlier this year may prove to be an illusion if asset levels follow a similar path to bond yields. Why subject plan assets to the whims of the markets? Cash flow match a portion of your assets (perhaps your bond allocation) to your plan's liabilities and secure the promised benefits while eliminating interest rate risk for that portion of the liabilities that are defeased.

Creating more volatility

An interesting analysis by Deutsche Bank suggests that public pension systems should have rebalanced a greater sum of plan assets to fixed income following the terrific first quarter performance provided by US equity markets. DB's analysis found that public pension system's added only $3.6 billion to fixed income as opposed to >$130 billion had they maintained a static allocation from the previous quarter. Clearly, this hesitancy to rebalance has helped in the short-term as equities continued to advance, but what does this suggest for the future? We've been taught that buying low and selling high is a winning strategy. We also know that trying to time markets is also incredibly difficult, which is why asset allocation targets and ranges around those targets have been established as a tried and true discipline.

There are numerous forces at work impacting this lack of an asset allocation action, including an expectation that the US would experience rising interest rates due to escalating inflationary concerns. A move upward in rates would likely lead to a very challenging environment for the typical bond manager. There is also the continuing focus on achieving the return on asset objective (ROA) that drives most asset allocation decisions. However, markets don't always behave as we might expect. Instead of rising, US interest rates have resumed their march lower, with both the US 10-year Treasury note and US 30-year Treasury bond hitting interest rate levels not seen since early to mid-February.

By continuing to expose these pension systems to greater equity exposure than long-term asset allocation frameworks have determined is appropriate injects more risk into these plans. I don't know how equities will perform during the next 6-months to a year nor do I have any clue as to where interest rates will go. Unless one is truly confident in one's ability to forecast these markets, prudence suggests following the course that has been determined through previous analysis. We think that taking equity risk off the table at this time makes sense. Furthermore, we'd suggest using bonds for their cash flows by matching the plan's liabilities, which provides the plan with a number of benefits that have been discussed in previous posts.

A guide for single-employer plans

The American Rescue Plan Act (ARPA) has brought many benefits to our retirement industry. I've been mostly focused on the significant impact that ARPA is likely to have on multiemployer plans, but the benefits for single-employer plans are vast, as well. Specifically, minimum contributions are likely to be lower and amortization periods start anew and are extended from 7 to 15 years.

Zorast Wadia, Principal, Consulting Actuary, Milliman, has produced a wonderful article on this subject. His piece "Defined Benefit Pension Funding Resurrection" covers important topics such as contributions, amortization periods, PBGC premiums, asset allocation, de-risking strategies, benefits, taxes, etc. With regard to asset allocation, Zorast believes that "it is a good idea for plan sponsors to revisit their plan asset allocations to make sure their funding and investment policies are in sync." He further suggests that "with funded ratios immediately improving under ARPA and minimum required contributions significantly muted over the next several years, shifting asset allocations from equities into fixed income seems like a viable alternative". We absolutely agree, especially given current valuations for US equities.

Defined benefit plans are the key to a successful retirement. Any legislation designed to reduce the cost of providing this important benefit, while possibly extending their use, is welcomed.

Challenging the Status Quo

The following is an excerpt taken from Thomas Jefferson's letter to James Madison. It reads, “I hold it that a little rebellion now and then is a good thing, and as necessary in the political world as storms in the physical...An observation of this truth should render honest republican governors so mild in their punishment of rebellions as not to discourage them too much. It is a medicine necessary for the sound health of government.” As we get set to celebrate our nation's rebellion this Fourth of July, these words remind me how important it is in our pension/investment industry to challenge the status quo.

We've witnessed a significant decline in the use of defined benefit plans. Is this a good thing? I've written quite often that I believe that it isn't, as we are asking untrained individuals to fund, manage, and then disburse a retirement benefit through a defined contribution-type fund with little know-how on how to accomplish this task. There are many reasons why DB plans have lost favor with pension sponsors, despite most American workers favoring them. One of the primary reasons has been the volatility in funded status and contribution expenses, which have resembled a ride on a roller-coaster. I believe that this has been brought about by the continuing focus on "achieving" a return on asset assumption (ROA) as opposed to the promise made to the plan participant (secure plan benefits or liabilities)… this is the reason that the plan exists in the first place.

Fortunately, despite this funding issue for many public fund plans they continue to provide these important retirement vehicles to their workforce. But will they be able to continue? Perhaps, but a change in how they are managed must be implemented. The "rebellion" that I encourage starts with a return to pension basics. It calls for a commitment on the part of everyone involved in pension management to focus first and foremost on the plan's funded ratio (assets/liabilities) and funded status (assets - liabilities) to drive asset allocation and investment structure decisions.

Since every plan's liabilities are unique, no generic index is appropriate for this evaluation. Each plan must have a routine (quarterly) review of how assets are performing relative to their liabilities. Once the plan's liabilities and cash flows have been modeled the allocation of assets can be done and monitored. But unlike today's strategy of having asset allocation focus on the ROA we recommend that the plan's assets be bifurcated into beta and alpha buckets. The beta portfolio will consist of fixed income assets whose objective is to cash flow match (defease) and fund the plan's benefit chronologically in a cost efficient manner with acceptable risk. The alpha bucket (the growth portfolio) will be invested in a variety of investment options that can now grow unencumbered since they are no longer a source of liquidity.

The defeasing of assets to liabilities is a strategy currently used by insurance companies and lottery systems. More importantly, it is how DB pension systems were run prior to the adoption of a return-oriented focus. The time is now to return to pension basics. To paraphrase Jefferson, a little rebellion now and then is a good thing, and as necessary in the investment industry as storms in the physical! Are you ready to join us in this quest?

Because They Can't Afford to Wait!

I've been blessed to be in the pension/investment industry for 40 years, and I truly believe that we possess tremendous responsibility to those that we serve - mainly the plan participant. But I'm often frustrated by the fact those that we have been asked to serve are not reaping the benefits that they were promised or deserve. I recently came across an article that touched upon Social Security. The gist of article pertained to a survey conducted by a major investment management organization whose primary focus was on when eligible recipients were likely to begin to claim the SS benefit (age 62-70). According to the survey, only 13% of those >60-years-old who haven't begun collecting their benefit said that they would wait until age 70 to maximize their benefit. Of those currently receiving a SS check, only 5% had waited to age 70.

Here's the issue: "Social security is the primary source of income for the majority of Americans we surveyed, which is why we were surprised to see so many deciding to take early SS payments at age 62, sacrificing their full benefits by tapping them early". "It might come down to not being able to afford to wait". Do you think? From the same survey: "for 52% of non-retired Americans and 58% of those retired, Social Security will be the primary source of income in retirement". As a reminder, the average monthly SS benefit is only $1,543/month. By taking it early at age 62, the beneficiary is forfeiting 30% of their possible benefit had they waited to full retirement age. When asked, 64% of those not retired and 62% of those that have retired said that benefits wouldn't be enough to live on."

Is the fact that a majority of Americans will be forced to live primarily on SS benefits something for us as a retirement industry to be proud? The demise of defined benefit plans and the rise of defined contribution plans in their stead is not helping matters. This substitution is creating an untenable situation for many Americans that are now asked to fund, manage, and then disburse a benefit with little experience and knowledge to do so. Unfortunately, DC offerings are proving to be glorified savings accounts for many Americans. They are often used to bridge periods of unemployment until a new job is found or retirement is thrust upon them. The gap between employment and the ability to claim SS can be years. Assets that were supposed to be used for "retirement" are often exhausted during this process. Regrettably, most American workers haven't come close to saving enough to weather such a storm let alone have a dignified retirement. The fact that this survey even mentioned that taking SS benefits prematurely might come down to affordability speaks to the dramatic lack of understanding as to what is truly occurring in our country.

Many people in our industry have done just fine from a financial perspective. Why is it that the people we are supposed to be serving haven't? Why do we have a majority of Americans living on very meager SS benefits? I find this shameful!